With Canadian businesses still struggling to cope with more restricted lending following the 2008 financial crisis, more and more are turning to bridge loans. While this loan type is usually associated with homeowners, entrepreneurs and businesses are increasingly turning to bridge loans, as well, to cover gaps in cash flow. This is done usually by factoring for cash flow.
Like so many financial instruments, these loans can work well or be disastrous. It all comes down to how they’re used and whether or not you and your businesses partners are fully aware of how they function.
Here’s how to make the right choice for you:
Bridge Loans: All the Basics You Need to Know
You won’t be shocked to hear that bridge loans are designed to function as a financial bridge. However, there’s a lot in that name. You don’t build a highway entirely out of bridges, since they’re for special circumstances.
In the same way, bridge loans are not for everyday use. They’re designed to function as a short-term line of credit. For example, they allow you to make a real estate purchase while still owning your current property.
The classic example is that you’re close to selling your existing property and have found the perfect new property to buy. You know you’ll have the funds soon, but you need access to that money now, so that you can buy your new property before selling the old one.
For businesses, and startups in particular, a bridge loan is often used to bridge two injections of investment by VCs or Angel Investors. In both cases, the loan allows you to bridge two separate periods of healthy cash flow and complete any purchase you need to make in the interim. But what’s the cost of this financial flexibility?
The Cost of Convenience
Unsurprisingly, you will have to pay for this convenience. Bridge loan interest rates can range from around 0.75% to 1.5% a month. That translates into 9% to 18% a year.
Low monthly rates mean such loans are more than convenient, if you expect to return the loan within a few weeks tops. You just need to be prepared if something goes wrong and your sale or investment is delayed for more than a couple of months.
The other cost element is the administrative fees. As with so many financial instruments, these can be difficult to estimate. A few thousand dollars is fairly normal, although the amounts will vary widely depending on the size of the bridge loan. In fact, it’s often advisable to go for a higher interest rate to avoid high fees.
Add these together and it’s entirely possible to pay $10,000 a month on a $500,000 bridge loan.
Whether you should get a bridge loan usually boils down to how confident you feel you’ll be able to repay the loan quickly. Your business plan will ultimately determine that. One great tool to help you estimate your payments is this bridge loan calculator offered by Pine Grove Software.
To Bridge or Not to Bridge: How to Decide
The most obvious first question to ask yourself is whether or not a traditional loan is possible. If it is, your bridge loan quest is over — it’s just not the best choice for you.
Bridge loans are mostly used as alternatives to bank loans, when a bank either can’t make the loan quickly enough or won’t loan the required amount. To get a bank loan, you must have (a) time and (b) a steady high income. For many new businesses, this means that bank loans are not an option. In this case, bridge loans can be your best fit.
Providers of bridge loans are simply willing to take more risk in exchange for higher interest rates and fees. This is great if you need cash now, and time is not a commodity you can afford.
The decision comes down to calculating the risks and costs of the loan in full. Working with a lawyer to review the details of the contract can be vital to ensure you understand all of the costs.
The final thing to bear in mind is that you have more options than simply bridge loans or traditional bank loans.
If you’re running a business with long supply chains and are running into the liquidity problems which often accompany them, you might already have the funds you need if you know how to extract them. Tools like invoice financing or invoice discounting may be able to free up the capital you need for your property investment. You can read more on important factors to consider when invoice financing or a bank loan.
There’s a growing world of alternative financing out there. Put simply, understanding your options puts you in the drivers seat. Jumping into a bridge loan without a full understanding can put your financial health at risk, so think before you jump and ensure you’re always well financed.